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2014 US macro must-knows for equity and fixed income ETF investors

Part 3
2014 US macro must-knows for equity and fixed income ETF investors (Part 3 of 5)

Fixed income ETF must-knows: Assessing duration and quality

Fixed income ETFs

The below graph reflects changes in popular fixed income ETFs since the 2008 crisis. As the bond market rally had softened and interest rates rose post-2013, long-duration bonds, as reflected in the iShares 20 Year plus ETF (TLT) have weakened. In contrast, shorter-duration bond ETFs, such as the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the Barclays High Yield Bond Fund ETF (JNK), have largely maintained their value, while the highly diversified Vanguard Total Bond Market ETF (BND), with a mid-level duration exposure of approximately 5.5 years, incurred much smaller duration-related losses.

For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Fixed Income ETFs 2014-02-26Enlarge Graph

Beware of risks: Credit quality

While the short duration aspect of both JNK and HYG might seem attractive to investors wary of rising rates, investors should bear in mind that both HYG and JNK also have significant credit risk embedded in their high yield and junk-rated bonds. Note that during the 2008 credit crisis, the AAA 20+ Year Treasury EFT and bond prices rallied strongly on a flight to quality, while on the other side of the credit spectrum, the BBB-B rated credit in JNK and HYG experienced significant declines. Similarly, in the other extreme set of circumstances—including rapid inflation or a sudden rise in interest rates—it’s also possible to see the credit component of HYG and JNK lead to underperformance of higher credit–rated bonds. Interestingly, the well-diversified higher-quality 5.5-year-duration Vanguard ETF (BND) exhibits much less volatility.

To see how ultra-short-duration fixed income ETFs with lower credit quality exposure compare to longer-duration fixed income ETFs with higher credit quality, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related series A flagging consumer price index contains the bear market in bonds.

Outlook–High Credit Quality & Longer Duration (TLT & BND) versus Lower Credit Quality & Mid Duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETF’s such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines, should interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current 10 Year Treasury Bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, it should be noted that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA-A rated bonds. In comparison to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus  HYG 3.98 & JNK 4.20), though is very much concentrated in government and high quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK) offers a similar duration of 4.20 Years versus HYG 3.98 years, holding 84.17% of its portfolio in Corporate Industrial, 7.65% in Corporate Utility, and 7.5% in Corporate Finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp, S, (0.62%), Sprint Communications (0.59%), and HCA Inc (HCA).

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